Thursday, April 27, 2006

By any measure, Goldman Sachs is a formidable company. The bank knocks the spots off its competitors, whether in pure “investment banking”, the traditional craft of underwriting and mergers and acquisitions in which it made its name, or in its new focus, trading for customers and its own account. Even compared with leaders in other industries, Goldman makes spectacular returns. Among its latest record-busting yardsticks was a 40% quarterly return on equity. The average pay-packet of its 24,000 staff last year was $520,000—and that includes a lot of assistants and secretaries.

This makes the bank an easy target for populist politicians and tabloid newspapers. The real reason why Goldman should matter to outsiders is not because it is a manufacturer of millionaires (good luck to it); but because it stands at the centre of a two-decade-long transformation of the financial markets and a new approach to risk.

Business risks that were once seen as a lumpy fact of life are now routinely sliced up and packaged into combinations that generally suit issuers and investors alike. At the heart of the change has been the development of huge markets in swaps, derivatives and other complex and often opaque instruments that allow the transfer of risk from one party to another. From small beginnings in 1987, the face value of contracts in interest-rate and currency derivatives is now more than $200 trillion—16 times America's GDP. A further $17 trillion is outstanding in (even newer) credit-default swaps, which allow bond investors to lay off the risk of issuers defaulting.

Led by Goldman, investment banks have innovated at a furious pace and changed the mix of their own businesses. They have taken on more risk as they have moved from more transparent markets, in which margins are slim, to more profitable portfolios of derivatives and direct private-equity investments. The face value of Goldman's derivatives exposure is more than $1 trillion, although the bank says that its net exposure, once you offset all its positions, is $58 billion, against shareholders' funds of $28 billion. The bankers' innovations have brought huge rewards to their industry. In the past decade it has garnered revenues of more than $125 billion, more than three times the level in the previous decade.

Simply the best

This huge new risk industry has produced gains for people far away from Wall Street and the City of London. Car companies have been able to hedge away many risks that once were seen as an incurable part of the business—and thus focus on what they do best. Pension funds have been able to shape their portfolios to fit their appetite for risk. Friction is bad for economies; the risk industry reduces it to all our benefits.

Yet the sheer size of the numbers involved does mean it is worth raising three questions. How exactly has Goldman and its industry achieved this? Can it be sustained? And what should happen if something goes wrong?

Like most of its rivals, Goldman is a difficult institution for outsiders to understand. Until 1999 it was a private partnership. With public ownership came greater reporting responsibilities, but precisely what Goldman is up to remains obscure. The bank likes to say that it still relies a lot on traditional investment banking, but Goldman's accounts show that its profits come increasingly from trading. The sharp-suited investment bankers act as a sales force for less-well-dressed colleagues who work out how to make money from swaps, options and direct investments.

Goldman was not the first to realise that new financial techniques had the potential to alter risk management for companies of all kinds. Bankers Trust, now part of Deutsche Bank, was arguably quickest off the mark. But once it joined the risk-management game, Goldman steadily accumulated market nous. It applied this by building a proprietary technology system, shunning the off-the-shelf products used by many of its competitors. People who have left Goldman say that this system is unmatched at rivals. One consequence is that Goldman seems confident that it can take more risks than its competitors do. Its trading revenues are the most volatile among big investment banks and it has the most days when it loses money. Overall, however, it makes the most money.

Inside the black box

But for how long? The market doubts the run of huge profits can last. Goldman's shares are valued less richly than those of competitors it so obviously outwits. Moreover, investment banks are less highly valued than less glamorous commercial banks and retail brokerage firms.

This could be because investors think Goldman will struggle to sustain the breakneck innovation that keeps it ahead of others. Goldman's ascendancy is already showing stresses—most recently the struggle to manage conflicts of interests across its business lines. Hank Paulson, Goldman's boss, recently chastised its London team of investment bankers for appearing too aggressive in their offers to buy companies, thereby threatening the bank's reputation for being an adviser. In Japan, for just this reason, some of Goldman's M&A customers have deserted it for rivals.

These kerfuffles show that conflicts of interest can probably be solved by market pressure rather than intervention by regulators. A bigger problem for both investors and regulators has to do with risk itself. Outsiders—and perhaps even insiders—find it hard to judge whether Goldman's business is sustainably good or has thrived thanks to a dose of unsustainable good luck and skill. In addition, the very improvements in risk management that have spread risk far and wide make it harder to know where risk is concentrated or how risks might combine to threaten the system's overall health.

So far central banks have concluded that the system is more robust than it was. But the trading models that have propelled Goldman will be tested one day. At worst, the bank itself—or, more likely, a second-tier rival or a hedge fund—might fall into the kind of dramatic spiral that killed off Long-Term Capital Management (LTCM), a hedge fund, in the late 1990s. Financial markets have always been subject to crises.

Any crisis would affect Goldman, because it is so intertwined with the system. The bank says it keeps plenty of liquid reserves against the dread day. It might well profit from any crisis (it did from LTCM). But the chances are that some banks, somewhere, will get into serious trouble.

If that happens, the losses of any bank will be for its shareholders; they should not expect any bail-out. The wider question has to do with systemic risk. If the much vaunted systems do not work, then the central banks will have to step in (as the Federal Reserve did with LTCM). In the past, though, such collapses did less damage to the financial system than the regulatory over-reaction that followed them. If policymakers were to respond to the next crisis by ushering in a more conservative regime that severely limited financial risk-modelling and risk-management, the global economy would be the poorer for it. That is what should stick in people's minds when the day comes. Until then, why not do something too often forgotten? Love Goldman or hate it, you ought to admire it and the system it epitomises. And hang on tight.